Ormat Technologies Inc (NYSE:ORA) outperformed the renewable electricity industry on the basis of its ROE – producing a higher 10.44% relative to the peer average of 6.08% over the past 12 months. Though, the impressiveness of ORA’s ROE is contingent on whether this industry-beating level can be sustained. This can be measured by looking at the company’s financial leverage. With more debt, ORA can invest even more and earn more money, thus pushing up its returns. However, ROE only measures returns against equity, not debt. This can be distorted, so let’s take a look at it further. Check out our latest analysis for Ormat Technologies
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 10.44% implies $0.1 returned on every $1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Renewable Electricity industry may want to choose the highest returning stock. However, this can be misleading as each firm has different costs of equity and debt levels i.e. the more debt Ormat Technologies has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Ormat Technologies’s cost of equity is 8.49%. Given a positive discrepancy of 1.95% between return and cost, this indicates that Ormat Technologies pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be dissected into three distinct ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue Ormat Technologies can make from its asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. We can assess whether Ormat Technologies is fuelling ROE by excessively raising debt. Ideally, Ormat Technologies should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The ratio currently stands at a sensible 71.72%, meaning Ormat Technologies has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden.
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Ormat Technologies exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For Ormat Technologies, I’ve put together three pertinent aspects you should look at:
- 1. Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- 2. Valuation: What is Ormat Technologies worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Ormat Technologies is currently mispriced by the market.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Ormat Technologies? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!